When Doug McCormick got serious about finding money for his Internet software concept, he figured venture capitalists would eat it up. No cookie-cutter e-commerce idea, his product solved a confidentiality issue for drug companies: how to release data destined only for doctors over the Web.

The trick was identifying physicians in cyberspace. Using the American Medical Assn.'s registry, McCormick designed software that screened for them and let companies create a detailed database of those who visited a site. Any drug or health-care company would want it, he figured.

Instead, McCormick's product baffled VCs, who knew nothing of the back-office problems of drug companies. "One [VC] flat out told us [they] can evaluate Internet plays or health-care plays, but not the two together," McCormick recalls.

"DOUBLE THE PAYOFF." A few months later, in November, 1998, McCormick ran into Brenda Gavin, president of SmithKline Beecham's $100 million venture-capital fund S.R. One at a venture fair in Philadelphia. While one VC firm nibbled daintily at the bait, Gavin, who had seen an earlier version of the software, took a healthy bite. Nine months later, S.R. One gave McCormick's Wynnewood (Pa.) company, Physician Verification Service (PVS), most of its $900,000 seed financing round and showed it how to pitch its product to big drug companies.

"We did the rounds of regular venture capital and got very close a few times. But in the end, they weren't willing to take the risk when we were at such an early stage -- we had no customers," says McCormick. On the other hand, "the corporate investor saw it as double the payoff -- a good investment that could promote its other businesses."

It's easy to overlook corporate funds. Buried in big-company structures, they're harder to find than the high-profile independents. Yet for entrepreneurs like McCormick, whose concepts few industry outsiders can evaluate, they're worth digging for. There's real money for young companies whose concepts fit into the strategic interests of larger ones. Nearly $5 billion, or 38%, of the $13 billion in U.S. venture money invested last year came from corporate funds, according to VentureOne Corp., which tracks VC data. And with many independent firms investing only in Web infrastructure and e-commerce, corporations are funding sectors that have been left behind. Health care and biotechnology are prime examples: Few conventional VCs have the patience for long research and testing anymore. S.R. One, for example, has funded Therion Biologies Corp.'s work on cancer vaccines. "They understand the risks and expenses," says Dennis Panicali, Therion's CEO.

Big companies betting on small ones include Ford, AT&T, Cisco, Intel, and Lucent Technologies in high-tech fields; Johnson & Johnson, SmithKline Beecham, and Dow Chemical in biotech and health care; and E.W. Scripps, McGraw-Hill (publisher of Business Week), and Reuters in media and information technology.

RECOGNIZABLE NAMES. The corporate types may be more patient, but they do want similar annual returns: at least 50% on seed capital and between 25% and 30% for later rounds of financing. In return, they offer industry-specific expertise in such areas as research and development, distribution, and marketing. Corporate VCs and independents usually structure their deals the same way -- cash for a large minority stake, though with corporate funders, entrepreneurs may be able to barter equity for R&D or a distribution agreement.

For some entrepreneurs, the money is almost beside the point. Take Kevin Kerns's company, Apropos Technology, which makes software that lets call centers identify top customers and route their calls to the head of the line. Allstate Insurance Co. took a third of Apropos' $2 million financing round -- a tiny stake. Yet, Allstate, the fifth U.S. call-center operator, is now Apropos' biggest customer and best reference. That's something no conventional VC can offer, Kerns points out: "If some venture-capital firm uses our product, we can't say, 'They use our product at X venture-capital firm.' That means nothing. But Allstate is a name people recognize."

Still, corporate venture capital isn't for everyone. Company units are typically slower than independent VCs to cement deals. That's a serious disadvantage for consumer e-commerce companies, for example, which need to get to market as fast as possible or risk being eclipsed by a fleeter competitor. Moreover, corporate brick-and-mortar interests may clash with an Internet startup's concept. That's what Mike Jewell, CEO of BirthdayExpress.com, which sells theme-party supply packages on the Web, found out. He turned down an unsolicited corporate offer when he realized the would-be investor really wanted BirthdayExpress.com to push its products. "Big corporations are trying to mold the Internet to their vision of the world," says Jewell, who raised $13 million from four independent VCs instead. "The Internet is molding itself and behaving how customers choose it to behave."

SCARY LINK.Close ties with one big client can hurt young companies -- especially early in their life cycle. "There is a risk trade-off in partnering with company A and giving company A a board seat when the relationship could hurt you with company A's competitor," observes Thomas Uhlman, president of Lucent's New Ventures Group (NVG), which exclusively develops ideas that come out of Bell Labs.

That's why some VCs recommend that entrepreneurs not solicit corporate capital until they know what -- if anything -- they'd lose by hitching their stars to one big name. A premature corporate link can also deter other investors, who may assume that a big partner will acquire a young company -- limiting their exit strategies. Such concerns aren't misplaced. "De facto, if not contractually, SmithKline Beecham sees everything we do first," admits S.R. One's Gavin, which means SmithKline has right of first refusal on everything in S.R. One's portfolio. Early on, in certain types of industries, this link can scare entrepreneurs away from corporate investment.

Probably the biggest drawback with corporate venture capital is simply that it's hard to find without personal contacts. Companies tend to ferret their VC operations away in the mergers and acquisitions, R&D, or business development departments. Only a third of companies list them as separate units, according to VentureOne. "I was lucky because I had the contact at S.R. One," admits PVS's McCormick. "If you asked me to find [venture capital] at Glaxo, I wouldn't have a clue how to do it." The National Venture Capital Assn., a trade group based in Arlington, Va., is trying to fill the information gap by drawing up a list of resources and contact names, which it plans to publish on its Web site (see "Where to Dig").

Entrepreneurs who have checked out both sides of the VC world say there are roles for each over the life cycle of many companies. "Corporate venture capital doesn't replace traditional venture capital," says John Stuelpnagel, CEO of Illumina, a fiber-optic-sensor manufacturer that has raised money from Dow Chemical. "They add different things." The rewards are there if you're willing to prospect in the giants' lairs.

By Margaret Popper in New York
margaret_popper@businessweek.com

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